Global Financial Crisis and Consequent Credit Crunch

Introduction

The global financial crisis which occurred in 2008 was one of the greatest events in financial and economic history. It is very rare to find a crisis of that magnitude. It was the worst global financial crisis that the world has ever witnessed apart from the 1930s Great Depression. The global financial crisis is believed to have had numerous causes but the most fundamental is the crisis in the subprime mortgage which could be summarized under “the greed factor”. All business entities acted to serve their interest since it was anticipated that the housing sector would boom. The crisis was marked by the bankruptcy of various leading financial institutions and the collapse of monetary markets like Wall Street. In the U.S., the global financial crisis was preceded by a loss of trust by U.S. citizens in the ability of their monetary system.

Soros (2008, p.37) asserts that whereas the U.S. subprime mortgage market is believed to have prompted the current financial crisis, the basis of the crisis derived from the flawed practices and institutions of the current financial system. In reality, the global financial crisis had both the real sector and financial roots, yet the paper exploits the financial root causes. The paper addresses the follow-up revival attempts by the government and the resultant spill-over effects of the crisis that are witnessed up to date. On account of the crisis and the resultant effects, the paper also highlights various moves by governments to mitigate the occurrence of such a crisis.

Events leading to the crisis

The Global Financial Crisis of 2008 was preceded by several events. The first event was the credit crisis in the U.S. that triggered off the crisis. The credit crisis had been forthcoming for the last twenty-five years since the world started using the dollar as its currency reserve. For many years, the whole world had pegged its currency on the dollar and used it as the medium of exchange. The resultant effect was the creation of a periodic economic boom that was frail and likely to fall (Obstfeld & Rogoff 1995, p.78).

Since then, any slump in the dollar would mean a slump in the economy of the whole world, a scenario that happened in the global financial crisis. Furthermore, the world trusted the notion that the financial market would stabilize the exchange rate and create equilibrium (Soros 2008, p.67). This however leaves the system prone to business manipulation by the financial institutions who want to amplify their gains.

IMF (2008) reported that the credit crunch witnessed in 2008 was set off by the slump in the U.S. housing sector. From as early as 2005, the housing sector in the U.S. came under a severe decline in prices. This decline in prices is anticipated by buyers who took out huge loans from lending institutions to buy the houses. The resultant effect was that traders acquired houses not for settlement, but in anticipation that the market would again rise and operate at a higher profit margin (IMF, 2008).

Having anticipated the likely results, the U.S. subprime mortgage industry offered loans to people with poor credit or no cash for a down payment. This caused a balance of payment crisis as the lending institutions attempted to support the declining currency which ensued due to excessive borrowing. Such efforts created a deficit in the lending institutions’ reserves leading to inflation and the final setting in of the credit crunch (Krugman 2007, p.314). The events forced the U.S. subprime lenders to be declared bankrupt.

Across the world, the bankruptcy in the U.S. major subprime institutions reverberates as many monetary and financial institutions peg their currencies on the dollar. The inflation and the consequent decline in dollar value caused other currencies to decline. Due to the bankruptcy of the subprime industry, the U.S. government intervenes by cutting the interests rates of its Federal reserve bank to a historical low of 0.25%. This crippled the Federal Reserve Bank by depleting its reserves to a point that it could no longer support the dollar against the escalating inflation (Krugman 2007, p.316). As a result, lending institutions and traders in the world attempted to sell off their dollar reserves and this set off the credit crisis.

Despite the fall in the subprime section of the U.S. economy, the build-up to the crisis was a result of poor government intervention in the way lending institutions conducted their business. It was believed that before the crisis; free markets were more profitable than regulated markets. This culminated in deregulation of the lending industry in the U.S. with the notion that it posed less risk. Such notions gave banks leeway to innovate and introduce new lending procedures even without seeking approvals from the Federal Reserve Bank. Deregulations led to appreciations in the mortgage market with abnormal increases in the home markets and retained risks by the mortgage lenders. The crisis began with an abrupt halt in the booming housing market and constant prices that led to the inventory build-up. With the falling prices and home sales, the subprime-mortgage industry collapsed leading to the financial crisis

Incentives were provided to the lending institutions in form of bailouts in case of bankruptcy, which further put the lending sector at risk. Due to the incentives and security tenures given to the lending institutions, booms were experienced and these were manipulated by traders for more gains (Soros 2008, p.75). The booms were however short-lived as they were volatile and ended up in the financial crisis.

Financial and Economic consequences

The 2008 global financial crisis led to a revolution in the world financial system and the reorganization of the global economy. It was found that economic and financial policies that were pegged on the traditional standards of economic theories such as the aggregate demand and interest rates were inadequate (Minsky, 1980, p.519). The consequences of such policies as pegging the currency on other major currencies as the dollar and euro led to a sharp reduction in the volume of global trade. In other words, many countries that fixed their currency on the US dollar or Euro were affected as the value of the dollar declined. The volume of exports went down as the dollar continued to depreciate (Peters 2010, p.12). This was attributed to the declining prices as the dollar continued to decline. As a result of the decline in international trade, the growth rates of various economies also declined throughout the world.

Empirically, the crisis led to the prolonged collapse of the asset market. The low-interest rates plus huge foreign funds inflow made many people borrow funds and buy houses. Similarly, the banks were willing to lend funds regardless of creditworthiness. The higher demand led to increased prices that in turn led to an increased supply of new houses. Consequently, the rise in the housing supply drove the prices up. That is, the supply curve shifted upwards while the demand curve shifted towards the right thus pushing the prices upwards.

Financial and Economic consequences

The high prices made it rather difficult for house purchasers to repay the loans with the emergence of the financial crisis.

The decline took an average of six years before it stabilized. Besides, the crisis led to profound declines in employment rates and the total output. On average, the employment rate declined by over 7% while the GDP per capita fell by over 9% within two years (Calvo et al, 2009, p.242). The most significant consequence became apparent in government finances. The government revenues were adversely affected as tax revenues significantly declined as economic conditions continued to deteriorate. The government deficits remarkably worsened and the real value of fiscal debt almost reached an exploding point of about 86% (Calvo et al. 2009, p.245).

Conversely, the consequences of the 2008 global financial crisis led to a sharp decline in the exchange value of the US dollar. The value of the US dollar plummeted considerably against other currencies (Minsky, 1980, p.520). As the FRB ran out of reserves due to consistent bailouts, it could no longer defend the dollar against the decline in the dollar value. Financial institutions in the US and worldwide collapsed as they were declared bankrupt.

Severe and risky lending habits had forced the institutions to be declared bankrupt. The FRB of the U.S. and other Central Banks were forced to pump a huge amount of their reserves into the bailout programs. The financial problem thus spread from one sector to the other, starting with the subprime section to the insurance companies, and then to the other debts related financial sections. As one section collapsed, the other sections followed suit.

Government responses

Owing to this widely felt crisis, it was the responsibility of the governments, central banks, and other larger global financial institutions such as the IMF to come up with appropriate short-term and long-term policies that would cure the current problem and avert future crises. The short-term policies were in form of fiscal rescue plans rather than monetarist in nature. These included offering various stimulus packages, institutional bailouts besides implementing a combination of strict monetary and fiscal policy measures. It is estimated that the federal government spent around $ 1 trillion to recover from the financial crisis.

Taxpayers were given cash handouts while the governments increased their financial spending on long-term projects. These were regarded as the short-term viable policy measures that were to be adopted to rescue the global financial crisis (Peters 2010, p.22). Long-term policies were aimed at preventing any future crisis. These policy frameworks were to deviate from the current policies that are pegged on the standard monetarist approaches and provide new stabilities in the financial market. Albeit aftershocks of the GFC are still experienced, the crisis itself came to an end amid late 2008 and the middle of fiscal 2009.

Lessons to be learned

In summary, policymakers need to learn that the macro-economic policies including those that regulate the financial sector need to be revised. As Minsky (1980, p.520) claimed, the modern economic system, sophisticated financial systems, and the macroeconomic policies derived from the standard economic theories are continuously becoming irrelevant and a recipe for a big economic slump. Moreover, governments should realize that the globalized trade in commodities has tied many countries together; therefore a crisis in one state will automatically affect other countries too.

It should equally be noted that all economic downturns and financial crisis always have their origins in the industrialized countries and not necessarily from emerging economies as have always been perceived. Developed countries including the U.S. need to devise proper economic and financial policy measures that will not allow such a crisis to reappear. Finally, each country must be prepared for any economic eventuality by self-insuring against any future crisis. This can be ensured via implementing robust financial and economic policy structures such as holding adequate foreign exchange reserves.

References

Calvo, G, Izquierdo, A & Loo-Kung, 2009, “Relative price volatility under sudden stops: The relevance of balance sheet effects”, Journal of International Economics, vol.9 no.1, pp.231–254.

IMF 2008, World economic outlook: world economic and financial surveys, International Monetary Fund, Washington, D.C.

Krugman, P 1979, “A model of balance-of-payment crisis”, Journal of Money, Credit, and Banking, vol.11 no.3, pp. 311-325.

Minsky, HP 1980, “Capitalist financial processes and the instability of capitalism”, Journal of Economic Issues, vol.14 no.2, pp. 505-521.

Obstfeld, M & Rogoff, K 1995, “The mirage of fixed exchange rates”, Journal of economic perspectives, vol.9 no.4, pp. 73-96.

Peters, M 2010, What the 2008/2009 world economic crisis means for global agricultural trade, Diane Publishing, Pennsylvania, US.

Soros, G 2008, The new paradigm for financial markets: the credit crisis of 2008 and what it means, Public Affairs, New York, NY.

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